Term Sheets: Binding & Non-Binding

Guest post by Teresa Daggett

First, let’s get the terminology of term sheets out of the way. Whether the document that outlines your deal is called a “term sheet,” a “memorandum of understanding” or a “letter of intent,” these terms mean essentially the same thing. We will use “term sheet” in this article, but the other terms could easily be substituted. The differences between these three are merely stylistic.

Why a term sheet?

The decision makers for a business have decided to do a deal. The deal may be for one company to buy another company, or the sale of stock or promissory notes to investors, or for some other reason. For purposes of this article, we will assume that the term sheet is for the purchase of one business by another business. Once the parties have determined the major points of the deal, they ask their attorneys to draft a term sheet containing the key provisions that they have agreed on. Invariably, the attorneys will also raise questions about other provisions that the parties may want to add to the term sheet.

By drafting a term sheet, the parties can identify their major issues before committing time and money to due diligence and the far more extensive drafting involved in the definitive agreements. In addition to the provisions in the term sheet, the parties can identify “deal-breakers” and create momentum to move the deal along. Some or all of the provisions in the term sheet can be specified as “binding” or the entire term sheet can be “non-binding and for discussion purposes only.”

What are often “binding” terms in a substantially non-binding term sheet?

Exclusivity period. Our hypothetical buyer wants an exclusivity period during which the seller cannot entertain any other offers for its business. Our hypothetical seller thinks the buyer may not have the financial resources it claims in order to buy seller’s extremely (in its mind) valuable business, and therefore the seller does not want an exclusivity period. If our buyer is successful in its bid for an exclusivity period, this will typically be binding on the parties, and the seller will need to stop courting other potential buyers during the exclusivity period.

Confidentiality. Another term that is typically binding if included is the confidentiality of the term sheet, its terms, and the negotiations between the parties. We all know that a promise to keep something a secret is easily broken. However, the statement that the confidentiality provision is binding will put the parties on notice to keep this deal secret until the parties are ready to announce it. At a minimum, this provision sets up a moral obligation to keep the deal secret.

Fees and expenses. Often a term sheet will include the binding term that each party is responsible for its own fees and expenses prior to closing. Costs can include legal, accounting and investment banking fees and out-of-pocket expenses.

Conduct of the business. The business that is being purchased is not going to be worth much if the seller decides to sleep in every day and not conduct the business as usual. A commonly used binding provision is that “seller will conduct its business in the normal and ordinary course, consistent with prior practices.”

Bifurcate! If your term sheet has binding and non-binding provisions, be sure to be clear which are binding and which are not. Bifurcate the two types of provisions, or set out a provision that states that the term sheet is not binding except for Sections X, Y and Z.

What other provisions may be in a term sheet?

Type of transaction. Going back to our hypothetical seller and buyer, is the stock or partnership interest being sold? Alternatively, are only the assets being sold? If this is an asset sale, what assets are included and what are excluded? Be sure the term sheet clearly states what is being sold.

Price and payment terms. Price is one thing that is usually agreed on before the lawyers get involved. However, the payment terms may not have been decided yet. Will the seller get partial payment at closing and then carry a note? If so, what will the terms of the note be? If there is a note, will the buyer provide a personal guaranty? Will there be a holdback for certain contingencies? Or an escrow? How much of the deal consideration will be risk to secure the representations and warranties? How long will the representations and warranties last? Is there a minimum claim size (a basket), and does it tip? (A tipping basket is a minimum claim threshold that allows the buyer to recover from dollar zero of damages once the minimum has been surpassed; as opposed to a deductible.)

Treatment of outstanding stock options, warrants and convertible notes. If a corporation is being sold and the company has any of these types of securities outstanding, the parties should address how to treat these for the least disruption to the business.

Key employees. If there are one or more key employees, the buyer will want to be sure that they will stay with the company after the closing. The arrangement may include employment agreements, board seats, or stock options. Similarly, if there is a key employee who will not remain, will a severance payment and a noncompetition/nonsolicitation agreement be part of the deal?

Due diligence. The buyer needs to know what the seller’s business actually consists of. Likewise, the seller needs to know that the buyer has the financial wherewithal to pay. The due diligence provision of a term sheet will typically state that the parties will sign a mutual confidentiality agreement and then disclose “such documents and information as reasonably requested, so that each party can perform a full investigation of the other’s business and legal conditions.”

Noncompetition. The buyer may ask the seller to not compete with the buyer after the closing. If the seller is sailing off into retirement, this may not be a point of negotiation. On the other hand, if the seller wants to start a business that is similar – but not directly competing with its current business – the parties may be able to reach agreement on a somewhat narrow definition of noncompetition, either in terms of geography, length of time, or type of business.

How elaborate should the term sheet be? Term sheets do not have to be long, but it is a good idea not to avoid hard issues if addressing them later will be a disadvantage to you. In other words, it depends on whether you are the buyer or the seller. In our hypothetical sale of a business scenario, it would usually benefit the buyer to avoid saying in the term sheet how long the representations and warranties will last, and how long after the closing the seller may be liable, and for how much. But for the seller, these issues are critical. A seller does not want to put off negotiating these items until later in the deal, typically.

Can the term sheet be deemed to be binding – even if it does not say that it is?

This may be a tough call if either party has partially performed or the term sheet was so heavily negotiated and reads so much like a definitive agreement that the definitive agreement would be a mere formality. We generally recommend that the term sheet be more of an outline of the terms of the deal and not contain sentences such as “All warranties, representations, covenants and agreements, including indemnities and releases hereunder, made by Seller and Buyer shall be deemed and construed to be continuing warranties, representations, covenants and agreements which shall survive the Closing.”

The problem with a term sheet appearing too much like a definitive agreement is that, if challenged by one of the parties, a court may impose its own interpretation of commercially reasonable terms.

Aside from the terms that should be binding, to ensure that the remainder of your term sheet is non-binding, consider:

• The parties contemplate a later, formal agreement

• Use the term “prospective buyer”

• Make closing subject to financing and satisfactory due diligence

• Avoid the terms “will” and “shall”

• Avoid performance requirements before closing, as performance may give rise to a promissory estoppel claim

This article is not intended to be an exhaustive discourse on the subject of binding and non-binding provisions in a term sheet. Rather, we just want to highlight some things to consider when drafting your term sheets.

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Venture Capital Office Hours with Voyager Capital

UW students and faculty interested in startups can talk monthly, face-to-face, with a venture capital investor and startup attorney.  Randall Lucas of Voyager Capital and I hold open office hours the first Wednesday of each month at the University of Washington.

Who comes to see us?  A wide range, from skateboard-toting sophomores who have coded up an iPhone app, to senior researchers considering commercializing robotics technology, to rising seniors considering whether to work at a startup and what “stock options” are — all have come by to chat during open office hours.

You can find us at the Information School (Mary Gates Hall, iLounge 4th floor) from 10-11, and then at the Computer Science School (Allen Center, atrium) from 11-12. We do these typically on the first Wednesday of every month, while school is in session.  (If you want to talk during summer vacation, drop us a line and we’ll set something up.)

So, if you’d like to come see us, we will be there on Wednesday, March 1.  Happy to give you feedback on your startup ideas, guidance on thinking about intellectual property, or suggestions on raising capital — or just to hear what you’re excited about working on.

 

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Dear IRS: Let’s Make the Filing of 83(b) Elections Easier

Right now, the law sets an unfair tax trap for company founders.

The 83(b) Election Tax Trap

When founders come together to form a startup, they usually put vesting on their shares. They do this for tax reasons.

Here are the tax reasons to put vesting on shares: When a company issues stock to a service provider, the service provider’s receipt of the stock is taxable to the service provider.

For example, if you joined a company, and the company wanted to pay you in stock for services performed (say, 10,000 shares for each calendar quarter of service), you would have a problem. Each time the company issued you shares, you would owe taxes on the value of the shares received. This would be the case even if you couldn’t sell the shares to pay the tax (private company shares can’t be re-sold, generally).

This is a flaw in our income tax code, but it is a flaw that shows no signs of being fixed.

How Do Founder’s Get Out of this Mess?

The tax code is not entirely anti-founder. It gives them an out. Here is how it works:

Instead of the company paying you 10,000 in shares for each calendar quarter of services, the company will issue you all of the shares up front, so that you can pay tax on them now, at today’s value. But the company will retain the right to repurchase them at the price you paid if you leave before your service period is expected to end. Typically this right to repurchase at the price you paid lapses monthly over the vesting period, usually with a cliff vesting period at the front end.

This is a nifty tax trick. If the shares are worth a small amount of money now, because the company was just formed, you can pay tax today (and hopefully not very much).

But to not pay tax when the shares vest, you have to file an 83(b) election with the IRS within 30 days of receiving the shares subject to vesting.

The 83(b) election is the only way to avoid a terrible tax outcome when vesting conditions are imposed on founder shares.

If a founder files the 83(b) election with the IRS within 30 days of receiving his or her shares, the founder won’t have any more tax consequences associated with their shares until they sell them. If they hold them for more than a year and sell them, any gains will be taxed as long-term capital gain.

If the founder misses the 30 day deadline, each time their shares vest they will owe ordinary income tax if the value of the shares has increased. This affects not only the founder adversely, but also the company, which must withhold and remit taxes to the IRS if the founder is considered an employee for federal income tax purposes.

Why does the tax code treat founders this way? In almost all instances when an 83(b) election is filed, no additional taxes are due. The 83(b) tax is a tax on the unprepared or the un-initiated. As such, it is not fair tax policy.

I have written that Congress should amend Section 83(b) to reverse its presumption.  In other words, deem the election made if at the time of receipt of the shares no additional tax would be owed, because the person paid FMV for their shares.

There are other simple fixes too. How about just require the attachment of the 83(b) election to the Form 1040 for the year? In other words, delete the 30 day filing requirement?

Or, how about this? Allow electronic filing of 83(b) elections. Right now, the tax code and regulations are silent on whether electronic signatures on Section 83(b) elections work. This is a shame. The result is that to be safe, the recommended advice is to file origanally signed elections, which makes these elections more difficult to file. Some companies, such as eShares, are taking the position that electronic signatures will not be disputed by the IRS. I applaud the approach. But if we have a pro-business administration right now, the very least that ought to happen is the IRS ought to publish guidance that electronic signatures are completely acceptable in this context.

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Washington State Equity Crowdfunding Update

Good news! Senators Fain and Mullet have sponsored SB 5680 in the Washington State Senate. This is the same bill as HB 1593 in the House.

The bill would make important technical improvements to Washington State’s equity crowdfunding law

The highlights of the bill include:

  • Allowing Delaware corporations to use Washington State’s equity crowdfunding law.
  • Bringing the Washington State law into alignment with the federal exemptions now in place (we have a new federal exemption, Rule 147A).
  • Allowing accredited investors to participate in Washington State equity crowdfunding offerings without a limit on the amount of their investment.
  • Repealing the poison pill of having to publicly disclose executive officer and director compensation; instead, disclosure will just be required to shareholders and the DFI.
  • Allows companies to sell “[a]ny type of equity or convertible debt security” under the exemption (this will allow companies to sell convertible debt).

This is a great bill, and should result in companies using Washington State’s equity crowdfunding law.

The public hearing on the Senate bill is currently scheduled for February 9th. Anyone interested in testifying can come down to Olympia and sign up and be heard in support of the bill.

If you want to track the progress of the bill, you can track it here.

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Washington State Equity Crowdfunding Update

My colleague Danny Neuman and I testified this morning in support of HB 1593. This bill would improve the Washington State equity crowdfunding law.

The bill is sponsored by Representatives Vick and Kirby.

HB 1593 Would Do a Number of Helpful Things

HB 1593 would do the following:

  • Eliminate the quarterly public disclosure of executive officer and director compensation. Instead, there would be a required annual disclosure to the Company’s shareholders and the DFI.
  • Allow “accredited investors” to invest an unlimited amount in approved crowdfunding offerings.
  • Align the statute with new SEC regulations on Rule 147A offerings. This would allow companies incorporated in Delaware to use the law.
  • The bill would also allow companies to sell convertible debt or “any type of equity.”

The Washington State DFI testified in favor of the bill.

Hopefully this bill moves to passage and signature by the Governor this year. It would be a good series of improvements in the law. HB 1593 will make the law more accessible to companies and more desirable as a fundraising tool.

If you would like to know how to support the bill, email either me or Danny at wallin@carneylaw.com or neuman@carneylaw.com and we can give you some ideas.

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Congress: Please Fix 83(b) Elections

Congress is trying to make life easier for early stage and startup companies. This is good.

But so far, nothing has been proposed to fix Section 83(b) of the Internal Revenue Code.

Section 83(b) haunts every founder who receives shares subject to vesting.

If you are founding an early stage technology company with other founders, you will probably impose vesting on all of the shares issued to the founders. Vesting in this context means the following: if you quit providing services, the company has the right to buy back your “unvested” shares. The purchase price is the lesser of either (i) the FMV of the shares at the time of repurchase, or (ii) the price you paid for them (usually this is not a big number). This lower-of-fmv-or-cost repurchase right lapses over the vesting period, usually 4 years with a cliff of some kind.

Vesting is critical to include in company formation documents. If a 30% founder leaves, your company will essentially be un-fundable if a 30% owner is no longer working at the company.

But the current tax law does not make life easy for founders in this circumstance.

The Current Tax Law

The current tax law requires founders to file an 83(b) within 30 days of receiving their shares or suffer horrible, potentially debilitating tax consequences.

If you file the election, you typically won’t owe any tax as a result of filing. And your filing the form timely means that you won’t owe any tax when your shares vest.

If you don’t file the election, you will owe tax when your shares vest if the shares have gone up in value. The tax you owe will be based on the difference between the fair market value of the shares at the time of vesting over what you paid for them. If you are an employee, you will have to write a check to the company so that the company can send the funds to the IRS to pay the employee’s side of income and employment tax withholding. This can get expensive fast.

The tax code should not be written like it is now. We shouldn’t put founders on a 30 day ticking time bomb whenever they found a company. This is hostile to people founding companies.

Instead, we should reverse the presumption in Section 83(b). What I mean is that an 83(b) election is “deemed filed” if the Founder would not owe any tax as a result of filing it.

This would allow founders to sleep at night, and making forming and starting companies easier. Isn’t that what we want Congress?

I drafted proposed legislation along these lines a few years back. You can find it here.

If you happen to run into legislators or legislative staff working on federal tax issues, please mention this idea to them.

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The Financial Choice Act: How to Make it Better re Form D

Congress is preparing a bill known as the Financial CHOICE Act of 2016. There is a lot in the bill (and so it is worth scanning the table of contents for issues you might care about). One of the provisions of the bill, Section 1066, would revise the Form D filing requirements to make them easier on companies in general, including startups.

For the sake of clarity, Section 1066 makes it clear that the SEC is not to condition the availability of the exemption under Rule 506 on the filing of the form. This is good, but it leaves a gap in the law.

Many states require issuers to file the Form D in their state if the company is either resident there or has investors resident there. This means that even if the Congress clarifies that a federal Form D filing is not required, companies will still have to file and file with sometimes a variety of states. Many states impose substantial filings fees (e.g., $525 in Pennsylvania). Other states impose late filing fees (e.g., New Mexico).

Let’s fix 1066 to fix the state problem.

Let’s expressly add to Section 1066 that no state securities law administrator or authority can condition the availability the exemption on the Form D filing as well.

If you know anyone who is working on this bill, please suggest this to them. I am going to try as well.

 

 

 

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Recommended Improvements to Washington’s Equity Crowdfunding Law

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By Daniel Neuman.  I am a corporate and securities lawyer, working primarily with startups and early-stage companies in Seattle.

I testified yesterday before the Washington State House of Representatives Business & Financial Services Committee regarding the state’s Equity Crowdfunding law, and presented a list of recommendations for how to improve the regulations and make the law a more effective fundraising tool.

Raising money is a hard job for startups. It is made harder because there is a lack of angel and venture capital financing in Seattle and around Washington, especially relative to the level top tech talent we have here. I believe Washington’s Equity Crowdfunding law could become an important mechanism to fill this fundraising gap for startups by opening up the investment ecosystem to small investors. If implemented effectively, crowdfunding could be an alternative source of capital that will incentivize entrepreneurs to take risks needed to create successful, local businesses and will become an engine for job growth.

To date, however, there isn’t a single Washington company that has raised money under this law, and only two have even had their application approved by the state’s Department of Financial Institutions (“DFI”). By contrast, under Oregon’s equity crowdfunding law, Oregon companies have raised $450,000. While there are some important differences (a maximum raise of $250,000 in Oregon vs. $1M in Washington), Oregon has much less onerous regulations. We should push to amend and repeal some of DFI’s regulations. I recommend:

  1. Don’t require public disclosure of executive officer and director compensation. Disclosure to shareholders is sufficient.
  2. Allow for convertible debt or straight debt, including revenue loans. Currently only equity is allowed. The most common way startups raise their initial funding round is through convertible notes.
  3. Don’t require review and approval by DFI, especially for smaller offerings (i.e., up to $250,000, like Oregon). This could lead to a more flexible two-tiered crowdfunding regulatory scheme with other lighter-weight requirements.
  4. Don’t require escrow, especially for smaller offerings. It’s just another costly barrier.
  5. Allow “accredited investors” to invest an unlimited amount. There’s no reason to cap them at $100,000.
  6. Amend our laws to be harmonized with the SEC’s new regulations, particularly Rule 147A, which allows for crowdfunded offerings to be advertised on the internet and social media so long as securities are only issued to intrastate investors.
  7. Allow online portals to earn a success fee (say 3-5%) upon closing a crowdfunded round without having to be a registered broker-dealer.
  8. Allow entities to invest in crowdfunded offerings.
  9. Allow the law to be used for real estate investments.
  10. Repeal DFI’s rule specifying the preferences that preferred stock must have. Such preferences are not market.

If these improvements are made, more Washington business will be able to get off the ground and prevent entrepreneurs from fleeing to the Bay Area or elsewhere in search of capital. It will also attract other companies to move here as we continue to develop a more robust startup landscape.

The Business & Financial Services Committee seemed genuinely engaged and receptive to making at least some of these improvements during yesterday’s hearing. The DFI also signaled its agreement with us that the law should address debt offerings and that the state should harmonize the rules to fall in line with the SEC’s recent amendments. I am hopeful that the legislature and the DFI will be able to implement these recommended improvements in the near future.

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The Accredited Investor Definition: Let’s Not Index it to Inflation

The first bill out of the new Congress next year might set the accredited investor definition to adjust with inflation. As the bill is currently drafted, every 5 years the financial thresholds would go up based on inflation.

The bill is called the Financial Choice Act. You can find it here.

I think this is a bad idea for the following reasons:

  • The inflation adjustments will slowly disqualify angels who meet the current standards, reducing the number of angel investors available to invest in early stage startup companies.
  • If inflation adjustments had been in place when the current financial thresholds had been adopted, we would have 1/3rd fewer angel investors than we do today.
  • Already, outside of Silicon Valley, finding angel investors to invest in companies is extremely difficult.
  • This automatic inflation adjustment will hurt middle America worse. It is harder to meet the income tests in middle America. In middle America, we ought to adjust the thresholds down to take into account regional variations in income.
  • Along the lines of the last point, check out this great article by Leslie Jump. She makes what I think is a great point. We need to facilitate getting angel and venture capital investment dollars into areas that have been traditionally under-served by those sources of capital.
  • As stated in the Comprehensive Summary of the Financial Choice Act:

“Private placement offerings are a key source of equity capital for many small and emerging companies that generate a disproportionate share of the new jobs in our economy. Because such offerings are generally available only to accredited and other sophisticated investors, it is essential that the SEC not overly restrict the pool of accredited investors.”

Oddly enough, the Comprehensive Summary of the bill doesn’t mention indexing.

  • Even though inflation has been relatively tame, it might ramp up at any time. The President-elect’s big infrastructure plans could heat up inflation, for example.

If you can think of any other reasons why you think indexing these standards to inflation is a bad idea, please share them. Let’s press this case. I think the early stage ecosystem will be harmed by indexing. Thank you.

 

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Indexing the Accredited Investor Standard to Inflation: A Bad Idea

Now that the election is over, it is unclear, at least to me, which direction startup public policy will take. It is in all of our best interests that we have a startup public policy that promotes innovation and creativity. Too often we have laws that slow us down, impede us, or flat out make it illegal, whatever new product or innovation it is we are working on. 

It appears that one of the first acts of Congress is going to be the Financial Choice Act. There are provisions of this act that will affect the startup ecosystem. We should make our voices heard if we care about this.

Section 452 of the Financial Choice Act would do the following:

  • Repeal Section 413 of Dodd-Frank. The primary effect of this would be to take out of the SEC’s hands the review and modification of the accredited investor standards. Section 413 also requires the SEC to review and issue a report on the definition every 4 years. You can read the first report here. This would apparently go away with the repeal of section 413 as well. I agree in general that the SEC should not be able to make the definition of accredited investor worse, but it ought to be able to make it better (meaning, bringing more people into the definition, perhaps, for example, by imposing investment limitations on individuals that do not meet the current financial thresholders). I liked the SEC’s first report on the matter. It had some good ideas. Such as allowing Indian tribes to qualify as accredited investors (by a weird quirk of the way the current SEC rules are written, Indian tribes do not qualify as accredited investors, even if they have tens of millions of dollars in assets and investments). 
  • Codify the financial thresholds to qualify as an accredited investor. I would also view this as a positive. 
  • Set the financial thresholds to qualify to automatically adjust with inflation. I view this as a negative. 
  • Create two new categories of accredited investor:
    • anyone who is currently licensed or registered as a broker or investment advisor by the SEC, FINRA, or an equivalent SRO, or the securities division of a state or equivalent state division responsible for licensing or registration of individuals in connection with securities activities; and
    • anyone the SEC determines, by regulation, to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA or an equivalent SRO.

Both of the latter two ideas are good ideas. But as far as testing in, I am not sure FINRA is the right entity to administer such a test. Wouldn’t it be great if individual state securities administrators could administer such a test? The young MBA grad, for example, who doesn’t have $1M in net worth, but is young and has a long investment time horizon, seems to me ought be allowed to test in.

Indexing is a Bad Idea

I know different people have different thoughts on this. But I personally think indexing the financial thresholds to adjust with inflation is a bad idea. Sure, inflation has been low for years. But for all we know we will go through a period again, in the not too far future, where we have significant inflation. If we do, then this law will start automatically defining people out of the category of accredited investor. I think it would be more logical to leave the current numbers in place, and if Congress decides to change them in the future, Congress can change them.

To put it in context, one of the early versions of Dodd-Frank would have adjusted the financial thresholds to inflation, going all the way back to when they were set. We estimated that 2/3rds of all angel investors in America would no longer have qualified as accredited investors.

If Congress wants to index something to inflation that will improve the business regulation environment, it ought to index the $600 1099 threshold to inflation. That number hasn’t changed in forever. If it had been set to adjust to inflation, it would be something on the order of $5,000 right now.

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